Watching the Fed: Structuring Quantitative Easing

Once Again…All Eyes on the Fed

The Federal Open Market Committee (FOMC) begins another two day meeting today, with the economy still seemingly stuck in second gear. At the recent Jackson Hole gathering of central bankers, Fed Chairman Bernanke outlined the case for yet another tranche of quantitative easing, expressing “grave concern” about the state of the labour market. The FOMC meeting follows the seemingly ground-breaking decision by the European Central Bank (ECB) to counter speculation about the imminent breakup of the euro by announcing its intention to buy, aggressively if necessary, the short-dated government bonds of periphery countries. The Fed would have welcomed this decision: break-up of the euro would have created a huge demand for dollars. This has usually resulted in an expansion of the Fed’s balance sheet via dollar liquidity swaps with other central banks. The Fed will want any further bloating of its balance sheet to be done with domestic considerations in mind, the most important of which is the sticky unemployment rate.

While the majority of Fed watchers are expecting a third tranche of quantitative easing to be announced this week, the composition remains uncertain. Most observers feel that a combination of longer-dated Treasury securities and mortgage backed securities (MBS) will be the FOMC’s favoured option. Before explicitly announcing the inception of any third tranche, the FOMC will also try to provide markets with some guidance of short-term interest rate policy.

Extension of the Current Policy Horizon

The Fed currently believes that the exceptionally low level of short-term interest rates will be warranted until late-2014. Extending the time horizon over which such super-accommodative policy prevails into 2015 will probably be required along with any formal announcement of a third tranche of quantitative easing. By extending the time horizon over which short-term interest rates will remain at these levels, the Fed will aim to reduce the volatility of long-term interest rates. Financial markets also seem to be taking this view of extending the horizon of the current policy interest rate: the volatility on 3-month options for 10-year interest rate swaps has receded to levels consistent with the time horizon extension into 2015.

Could the Fed Cut Interest on Reserves?

It is also felt that the FOMC may flirt with the idea of cutting the interest rate paid on bank reserves at the Fed. Prior to the collapse of Lehman Brothers, banks did not receive interest on reserves. The banks had long lobbied Congress, claiming that the failure to pay interest constituted an implicit form of taxation. This changed in the aftermath of the failure of Lehman Brothers: the Fed was permitted to pay interest on required and excess reserves. The massive injections of liquidity in 2008 created a huge surge in cash assets held by the banking system. The elevated level of cash assets remains intact: critics argue that paying interest on reserves has made banks become lazy by not encouraging them to engage in counterparty lending risk, even in the federal funds market. The ECB faced a similar situation and decided to cut the interest rate it paid to banks to zero at the beginning of July.

By reducing the interest on reserves, it is argued that banks would be forced to engage in greater risk-taking by expanding loans and leases. While it is conceivable that the Fed could cut interest on reserves, it is unlikely to have a dramatic impact on bank behaviour in isolation. Furthermore, the case for cutting interest on reserves in the US is less clear cut than Europe: US banks have already started lending again. Commercial and industrial loans have, for example, increased +14% over the past year. In contrast, outstanding commercial and industrial loans in the eurozone have declined by -1% over the past 12-months. Any reduction in interest on reserves in the US would accompany other policy measures, such as a “funding for lending” scheme. At a bare minimum, the Fed would like to monitor the effects of the ECB’s decision to cut its deposit rate on lending in the eurozone before contemplating a similar move. Time is not, however, on the Fed’s side.

The Corporate Sector Remains Cautious

One reason why Fed Chairman Bernanke mentioned possible inception of a third tranche of quantitative easing is the rising level of caution espoused by companies about the profits outlook. Corporate profits are a leading indicator of economic activity and the rising level of negative guidance for Q3 earnings will not have gone unnoticed by the FOMC.

It also appears that analysts have finally decided to shave their 2012 Q4 and 2013 H1 S&P500 earnings estimates against a backdrop of continued global macroeconomic uncertainty. The 3 biggest obstacles to better macroeconomic visibility have remained the same: 1) the US fiscal policy backdrop for 2013, 2) the arrival of the new Standing Committee in China and its attitude to further stimulus, and 3) a decisive resolution to the banking and sovereign debt crises in Europe. Against this backdrop, uncertainty about future after-tax returns on capital is very high, while the willingness to engage in aggressive working capital deployment is commensurately low.

One reason why the US economy is seemingly stuck in second gear is that corporate sector genuinely believes that we could get 3 bad outcomes in 2013 with respect to US fiscal policy, Chinese economic growth, and the European banking/sovereign crises. It is impossible to construct probability distributions to these events unfolding, hence corporate expectations about the long-term return on capital are based purely on convenient conventions. The upshot is that not only are expectations fickle, but also highly unstable. This results in a sharp and sustained rise in the demand for liquidity, blunting the efficacy of conventional monetary policy.

The high level of US corporate liquidity could well reflect a high precautionary demand for money to provide for contingencies requiring sudden expenditure. If this thesis is correct, it is tough to see how further quantitative easing by the Fed can speed up US growth. The Fed’s official view is, however, that quantitative easing has been effective. Fed Chairman Bernanke believes that quantitative easing has helped to lift employment levels by as much as 2 million. There are also signs that quantitative easing has gained traction in the US housing sector.

Quantitative Easing Produces Recovery in US Housing

Residential investment is no longer a negative contributor to headline GDP growth. The share of residential investment in GDP has, however, shrunk by 57% from its peak in 2005 Q3, implying a much smaller future contribution to headline GDP growth. Nevertheless, the compression in US housing activity appears to be behind us, partly due to the Fed. Falling mortgage rates, under the auspices of quantitative easing, have helped to enhance housing affordability. This development has, in turn, boosted buyer traffic and, ultimately, home sales.

The Fed recognised that housing played a key role in creating the Great Recession. Any monetary policy response, conventional or otherwise, had to contain measures to revive housing. The purchases of MBS and longer-dated Treasury securities succeeded in restoring liquidity into the MBS market and lowered debt service costs for households. The next round of quantitative easing could aim to boost housing further by concentrating future asset purchases in MBS. The composition and size of future asset purchases could well be determined by the latest update of the consensus economic outlook of the FOMC which is due to be discussed at this week’s FOMC meeting.

The Importance of Communication

In his recent speech at Jackson Hole, Fed Chairman Bernanke placed great emphasis on the importance of communicating the Fed’s policy intentions to financial markets. The big challenge for the Fed in extending forward guidance for the federal funds target is to convey whether the new cut-off date is purely arbitrary or conditional on certain economic factors. By making the extension dependent on certain economic factors, potential hawks on the FOMC could be persuaded to extend forward guidance.

The announcements of the first two tranches of quantitative easing outlined large-scale asset purchases to be carried out over a certain time period. Some commentators believe further asset purchases could involve an added element of flexibility, with the announced size of purchases being dependent on certain economic and financial conditions. Under these circumstances, it would be imperative for the Fed to convey what economic and financial metrics are being monitored for this “flexible” approach to have credibility.

Perhaps the biggest future communications headache for the Fed will be when asset purchases no longer help to reduce long-term interest rates. This situation would indicate that the private sector regards cash and government bonds as being perfect substitutes. Monetary policy would require urgent refinement, presenting major communication challenges. While this is not the case at present, the Fed may be tempted to skew further asset purchases towards MBS to avoid cash and bonds becoming perfect substitutes for each other any time soon. While the Fed has not been flawless in its conduct of unconventional monetary policy, it has been far more transparent than the Bank of England, thereby helping to explain why quantitative easing has been more effective in the US than the UK.

Summary and Conclusions

The ECB’s decision to purchase short-dated bonds of periphery eurozone governments reduces the risks of the Fed having to boost dollar liquidity swap facilities. A third tranche of quantitative easing is expected to be announced by the Fed this week, although the size and composition remain uncertain.

The Fed will also look to extend the time horizon of the current policy rate into 2015, thereby helping to reduce potential volatility in long-term interest rates. A cut in the interest paid on bank reserves may occur, but this remains a more remote prospect for the moment.

An increasingly cautious corporate sector will be one factor in prompting the Fed to embrace another tranche of quantitative easing. Elevated corporate liquidity is reflecting very high levels of uncertainty about the macroeconomic outlook and the likely impact on the after-tax return on capital.

Quantitative easing has been successful in reversing the contraction of the US housing sector. The Fed may try to ensure continued housing growth via skewed asset purchases towards MBS.

The transparency of the Fed’s communication policies will become increasingly important. The Fed needs to remove any potential ambiguities about its economic outlook and what factors it will take into consideration before any prospective policy change.                         

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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